This document discusses 7 principles of economics: 1. People face trade-offs when making decisions that require giving up one desirable option for another. 2. The cost of something is measured by what is given up to obtain it, known as opportunity cost. 3. Rational people make decisions at the margin by comparing small incremental changes in costs and benefits. 4. People respond to incentives of rewards and punishments that induce behavior. 5. Trade between countries can make all countries better off by allowing specialization and access to more goods. 6. Markets are usually a good way to organize economic activity through the "invisible hand" of supply and demand. 7. Governments can sometimes improve market

1. Principle 1: People Face Trade-offs
“There ain’t no such thing as a free lunch.” To get one thing that we like, we usually have to give
up another thing that we like. Making decisions requires trading off one goal against another.
Consider a student who must decide how to allocate her most valuable resource—her time. She
can spend all her time studying economics, spend all of it studying psychology, or divide it
between the two fields. For every hour she studies one subject, she gives up an hour she could
have used studying the other. And for every hour she spends studying, she gives up an hour that
she could have spent napping, bike riding, watching TV, or working at her part-time job for
some extra spending money. Or consider parents deciding how to spend their family income.
They can buy food, clothing, or a family vacation. Or they can save some of the family income
for retirement or the children’s college education. When they choose to spend an extra dollar on
one of these goods, they have one less dollar to spend on some other good.
When people are grouped into societies, they face different kinds of trade-offs.One classic trade-
off is between “guns and butter.” The more a society spends on national defense (guns) to protect
its shores from foreign aggressors, the less it can spend on consumer goods (butter) to raise the
standard of living at home. Also important in modern society is the trade-off between a clean
environment and a high level of income. Laws that require firms to reduce pollution raise the
cost of producing goods and services. Because of the higher costs, these firms end up earning
smaller profits, paying lower wages, charging higher prices, or some combination of these three.
Thus, while pollution regulations yield the benefit of a cleaner environment and the improved
health that comes with it, the regulations come at the cost of reducing the incomes of the
regulated firms’ owners, workers, and customers. Another trade-off society faces is between
efficiency and equality. Efficiency means that society is getting the maximum benefits from its
scarce resources. Equality means that those benefits are distributed uniformly among society’s
members. In other words, efficiency refers to the size of the economic pie, and equality refers to
how the pie is divided into individual slices. When government policies are designed, these two
goals often conflict. Consider, for instance, policies aimed at equalizing the distribution of
economic well-being. Some of these policies, such as the welfare system or unemployment
insurance, try to help the members of society who are most in need. Others, such as the
individual income tax, ask the financially successful to contribute more than others to support the
government. While achieving greater equality, these policies reduce efficiency. When the
government redistributes income from the rich to the poor, it reduces the reward for working
hard; as a result, people work less and produce fewer goods and services. In other words, when
the government tries to cut the economic pie into more equal slices, the pie gets smaller.
Recognizing that people face trade-offs does not by itself tell us what decisions they will or
should make.
Principle 2: The Cost of Something Is
What You Give Up to Get It
Because people face trade-offs, making decisions requires comparing the costs and benefits of
alternative courses of action. Consider the decision to go to college. The main benefits are
intellectual enrichment and a lifetime of better job opportunities. But what are the costs? To
answer this question, you might be tempted to add up the money you spend on tuition, books,
room, and board. Yet this total does not truly represent what you give up to spend a year in
college. There are two problems with this calculation. First, it includes some things

2. that are not really costs of going to college. Even if you quit school, you need a place to sleep
and food to eat. Room and board are costs of going to college only to the extent that they are
more expensive at college than elsewhere. Second, this calculation ignores the largest cost of
going to college—your time. When you spend a year listening to lectures, reading textbooks, and
writing papers, you cannot spend that time working at a job. For most students, the earnings
given up to attend school are the largest single cost of their education. The opportunity cost of
an item is what you give up to get that item. When making any decision, decision makers should
be aware of the opportunity costs that accompany each possible action. In fact, they usually are.
College athletes who can earn millions if they drop out of school and play professional sports are
well aware that their opportunity cost of college is very high. It is not surprising that they often
decide that the benefit of a college education is not worth the cost.
Principle 3: Rational People Think at the Margin
Economists normally assume that people are rational. Rational people systematically and
purposefully do the best they can to achieve their objectives, given the available opportunities.
As you study economics, you will encounter firms that decide how many workers to hire and
how much of their product to manufacture and sell to maximize profits. You will also encounter
individuals who decide how much time to spend working and what goods and services to buy
with the resulting income to achieve the highest possible level of satisfaction. Rational people
know that decisions in life are rarely black and white but usually involve shades of gray. At
dinnertime, the decision you face is not between fasting or eating like a pig but whether to take
that extra spoonful of mashed potatoes. When exams roll around, your decision is not between
blowing them off or studying 24 hours a day but whether to spend an extra hour reviewing your
notes instead of watching TV. Economists use the term marginal change to describe a small
incremental adjustment to an existing plan of action. Keep in mind that margin means “edge,” so
marginal changes are adjustments around the edges of what you are doing. Rational people often
make decisions by comparing marginal benefits and marginal costs.
For example, consider an airline deciding how much to charge passengers who fly standby.
Suppose that flying a 200-seat plane across the United States costs the airline $100,000. In this
case, the average cost of each seat is $100,000/200, which is $500. One might be tempted to
conclude that the airline should never sell a ticket for less than $500. Actually, a rational airline
can often find ways to raise its profits by thinking at the margin. Imagine that a plane is about to
take off with ten empty seats, and a standby passenger waiting at the gate will pay $300 for a
seat. Should the airline sell the ticket? Of course it should. If the plane has empty seats, the cost
of adding one more passenger is tiny. Although the average cost of flying a passenger is $500,
the marginal cost is merely the cost of the bag of peanuts and can of soda that the extra
passenger will consume. As long as the standby passenger pays more than the marginal cost,
selling the ticket is profitable. Marginal decision making can help explain some otherwise
puzzling economic phenomena. Here is a classic question: Why is water so cheap, while
diamonds are so expensive? Humans need water to survive, while diamonds are unnecessary; but
for some reason, people are willing to pay much more for a diamond than for a cup of water. The
reason is that a person’s willingness to pay for a good is based on the marginal benefit that an
extra unit of the good would yield. The marginal benefit, in turn, depends on how many units a
person already has. Water is essential, but the marginal benefit of an extra cup is small because
water is plentiful. By contrast, no one needs diamonds to survive, but because diamonds are so
rare, people consider the marginal benefit of an extra diamond to be large. A rational decision

3. maker takes an action if and only if the marginal benefit of the action exceeds the marginal cost.
This principle can explain why airlines are willing to sell a ticket below average cost and why
people are willing to pay more for diamonds than for water. It can take some time to get used to
the logic of marginal thinking, but the study of economics will give you ample opportunity to
practice.
Principle 4: People Respond to Incentives
An incentive is something that induces a person to act, such as the prospect of a punishment or a
reward. Because rational people make decisions by comparing costs and benefits, they respond
to incentives. You will see that incentives play a central role in the study of economics. One
economist went so far as to suggest that the entire field could be summarized simply: “People
respond to incentives. The rest is commentary.” Incentives are crucial to analyzing how markets
work. For example, when the price of an apple rises, people decide to eat fewer apples. At the
same time, apple orchards decide to hire more workers and harvest more apples. In other words,
a higher price in a market provides an incentive for buyers to consume less and an incentive for
sellers to produce more. As we will see, the influence of prices on the behavior of consumers and
producers is crucial for how a market economy allocates scarce resources.. A tax on gasoline, for
instance, encourages people to drive smaller, more fuel-efficient cars. That is one reason people
drive smaller cars in Europe, where gasoline taxes are high, than in the United States, where
gasoline taxes are low. A gasoline tax also encourages people to carpool, take public
transportation, and live closer to where they work. If the tax were larger, more people would be
driving hybrid cars, and if it were large enough, they would switch to electric cars.
The Incentive Effects of
Gasoline Prices
From 2005 to 2008 the price of oil in world oil markets skyrocketed, the result of limited
supplies together with surging demand from robust world growth, especially in China. The price
of gasoline in the United States rose from about $2 to about $4 a gallon. At the time, the news
was filled with stories about how people responded to the increased incentive to conserve,
sometimes in obvious ways, sometimes in less obvious ways.
Here is a sampling of various stories:
• “As Gas Prices Soar, Buyers Are Flocking to Small Cars”
• “As Gas Prices Climb, So Do Scooter Sales”
• “Gas Prices Knock Bicycles Sales, Repairs into Higher Gear”
• “Gas Prices Send Surge of Riders to Mass Transit”
• “Camel Demand Up as Oil Price Soars“: Farmers in the Indian state of Rajasthan are
rediscovering the humble camel. As the cost of running gasguzzling tractors soars, even-toed
ungulates are making a comeback.
that gasoline prices have soared to more than $4 a gallon. So this semester she decided to take an
online course to save herself the trip —and the money.

4. Principle 5: Trade Can Make Everyone Better Off
You may have heard on the news that the Japanese are our competitors in the world economy. In
some ways, this is true because American and Japanese firms produce many of the same goods.
Ford and Toyota compete for the same customers in the market for automobiles. Apple and Sony
compete for the same customers in the market for digital music players. Yet it is easy to be
misled when thinking about competition among countries. Trade between the United States and
Japan is not like a sports contest in which one side wins and the other side loses. In fact, the
opposite is true: Trade between two countries can make each country better off. To see why,
consider how trade affects your family. When a member of your family looks for a job, he or she
competes against members of other families who are looking for jobs. Families also compete
against one another when they go shopping because each family wants to buy the best goods at
the lowest prices. In a sense, each family in the economy is competing with all other families.
Despite this competition, your family would not be better off isolating itself from all other
families. If it did, your family would need to grow its own food, make its own clothes, and build
its own home. Clearly, your family gains much from its ability to trade with others. Trade allows
each person to specialize in the activities he or she does best, whether it is farming, sewing, or
home building. By trading with others, people can buy a greater variety of goods and services at
lower cost. Countries as well as families benefit from the ability to trade with one another. Trade
allows countries to specialize in what they do best and to enjoy a greater variety of goods and
services. The Japanese, as well as the French and the Egyptians and the Brazilians, are as much
our partners in the world economy as they are our competitors.
Principle 6: Markets Are Usually a Good Way to
Organize Economic Activity
The collapse of communism in the Soviet Union and Eastern Europe in the 1980s may be the
most important change in the world during the past half century. Communist countries worked
on the premise that government officials were in the best position to allocate the economy’s
scarce resources. These central planners decided what goods and services were produced, how
much was produced, and who produced and consumed these goods and services. The theory
behind central planning was that only the government could organize economic activity in a way
that promoted economic well-being for the country as a whole. Most countries that once had
centrally planned economies have abandoned the system and are instead developing market
economies. In a market economy, the decisions of a central planner are replaced by the
decisions of millions of firms and households. Firms decide whom to hire and what to make.
Households decide which firms to work for and what to buy with their incomes. These firms and
households interact in the marketplace, where prices and self-interest guide their decisions. At
first glance, the success of market economies is puzzling. In a market economy, no one is
looking out for the economic well-being of society as a whole.
Free markets contain many buyers and sellers of numerous goods and services, and all of them
are interested primarily in their own well-being. Yet despite decentralized decision making and
self-interested decision makers, market economies
have proven remarkably successful in organizing economic activity to promote overall economic
well-being.
In his 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations, economist
Adam Smith made the most famous observation in all of economics: Households and firms
interacting in markets act as if they are guided by an

5. “invisible hand” that leads them to desirable market outcomes. One of our goals in this book is to
understand how this invisible hand works its magic. As you study economics, you will learn that
prices are the instrument with which the invisible hand directs economic activity. In any market,
buyers look at the price when determining how much to demand, and sellers look at the price
when deciding how much to supply. As a result of the decisions that buyers and sellers make,
market prices reflect both the value of a good to society and the cost to society of making the
good. Smith’s great insight was that prices adjust to guide these individual buyers and sellers to
reach outcomes that, in many cases, maximize the well-being of society as a whole. Smith’s
insight has an important corollary: When the government prevents prices from adjusting
naturally to supply and demand, it impedes the invisible hand’s ability to coordinate the
decisions of the households and firms that make up the economy. This corollary explains why
taxes adversely affect the allocation of resources, for they distort prices and thus the decisions of
households and firms. It also explains the great harm caused by policies that directly control
prices, such as rent control. And it explains the failure of communism. In communist countries,
prices were not determined in the marketplace but were dictated by central planners. These
planners lacked the necessary information about consumers’ tastes and producers’ costs, which
in a market economy is reflected in prices. Central planners failed because they tried to run the
economy with one
hand tied behind their backs—the invisible hand of the marketplace.
Principle 7: Governments Can Sometimes
Improve Market Outcomes
If the invisible hand of the market is so great, why do we need government? One purpose of
studying economics is to refine your view about the proper role and scope of government policy.
One reason we need government is that the invisible hand can work its magic only if the
government enforces the rules and maintains the institutions that are key to a market economy.
Most important, market economies need institutions to enforce property rights so individuals
can own and control scarce resources.
A farmer won’t grow food if he expects his crop to be stolen; a restaurant won’t serve meals
unless it is assured that customers will pay before they leave; and an entertainment company
won’t produce DVDs if too many potential customers avoid paying by making illegal copies. We
all rely on government-provided police and courts to enforce our rights over the things we
produce—and the invisible hand counts on our ability to enforce our rights.
Yet there is another reason we need government: The invisible hand is powerful, but it is not
omnipotent. There are two broad reasons for a government to intervene in the economy and
change the allocation of resources that people would choose on their own: to promote efficiency
or to promote equality. That is, most policies aim either to enlarge the economic pie or to change
how the pie is divided. Consider first the goal of efficiency. Although the invisible hand usually
leads markets to allocate resources to maximize the size of the economic pie, this is not always
the case. Economists use the term market failure to refer to a situation in which the market on
its own fails to produce an efficient allocation of resources. As we will see, one possible cause of
market failure is an externality, which is the impact of one person’s actions on the well-being of
a bystander. The classic example of an externality is pollution. Another possible cause of market
failure is market power, which refers to the ability of a single person (or small group) to unduly
influence market prices. For example, if everyone in town needs water but there is only one well,
the owner of the well is not subject to the rigorous competition with which the invisible hand
normally keeps self-interest in check.

6. In the presence of externalities or market power, well-designed public policy can enhance
economic efficiency. Now consider the goal of equality. Even when the invisible hand is yielding
efficient outcomes, it can nonetheless leave sizable disparities in economic wellbeing. A market
economy rewards people according to their ability to produce things that other people are willing
to pay for. The world’s best basketball player earns more than the world’s best chess player
simply because people are
willing to pay more to watch basketball than chess. The invisible hand does not ensure that
everyone has sufficient food, decent clothing, and adequate healthcare. This inequality may,
depending on one’s political philosophy, call for government intervention. In practice, many
public policies, such as the income tax and the welfare system, aim to achieve a more equal
distribution of economic well-being. To say that the government can improve on market
outcomes at times does not mean that it always will. Public policy is made n ot by angels but by
a political process that is far from perfect. Sometimes policies are designed simply to reward the
politically powerful. Sometimes they are made by well-intentioned leaders who are not fully
informed. As you study economics, you will become a better judge of when a government policy
is justifiable because it promotes efficiency or equality and when it is not.
Principle 8: A Country’s Standard of Living Depends
on Its Ability to Produce Goods and Services
The differences in living standards around the world are staggering. In 2008, the average
American had an income of about $47,000. In the same year, the average Mexican earned about
$10,000, and the average Nigerian earned only $1,400. Not surprisingly, this large variation in
average income is reflected in various measures of the quality of life. Citizens of high-income
countries have more TV sets, more cars, better nutrition, better healthcare, and a longer life
expectancy than citizens of low-income countries. Changes in living standards over time are also
large. In the United States, incomes have historically grown about 2 percent per year (after
adjusting for changes in the cost of living). At this rate, average income doubles every 35 years.
Over the past century, average U.S. income has risen about eightfold. What explains these large
differences in living standards among countries and over time? The answer is surprisingly
simple. Almost all variation in living standards is attributable to differences in countries’
productivity—that is, the amount of goods and services produced from each unit of labor input.
In nations where workers can produce a large quantity of goods and services per unit of time,
most people enjoy a high standard of living; in nations where workers are less productive, most
people endure a more meager existence. Similarly, the growth rate of a nation’s productivity
determines the growth rate of its average income. The fundamental relationship between
productivity and living standards is simple, but its implications are far-reaching. If productivity
is the primary determinant of living standards, other explanations must be of secondary
importance. For example, it might be tempting to credit labor unions or minimum-wage laws for
the rise in living standards of American workers over the past century. Yet the real hero of
American workers is their rising productivity. As another example, some commentators have
claimed that increased competition from Japan and other countries explained the slow growth in
U.S. incomes during the 1970s and 1980s. Yet the real villain was not competition from abroad
but flagging productivity growth in the United States.
The relationship between productivity and living standards also has profound implications for
public policy. When thinking about how any policy will affect living standards, the key question
is how it will affect our ability to produce goods and services. To boost living standards,

7. policymakers need to raise productivity by ensuring that workers are well educated, have the
tools needed to produce goods and services, and have access to the best available technology .
Principle 9: Prices Rise When the Government
Prints Too Much Money
During the 1970s, for instance, when the overall level of prices more than doubled, President
Gerald Ford called inflation “public enemy number one.” By contrast, inflation in the first
decade of the 21st century has run about 2½ percent per year; at this rate, it would take almost 30
years for prices to double. Because high inflation imposes various costs on society, keeping
inflation at a low level is a goal of economic policymakers around the world. What causes
inflation? In almost all cases of large or persistent inflation, the culprit is growth in the quantity
of money. When a government creates large quantities of the nation’s money, the value of the
money falls. In Germany in the early 1920s, when prices were on average tripling every month,
the quantity of money was also tripling every month. Although less dramatic, the economic
history of the United States points to a similar conclusion: The high inflation of the 1970s was
associated with rapid growth in the quantity of money, and the low inflation of more recent
experience was associated with slow growth in the quantity of money.
Principle 10: Society Faces a Short-Run Trade-off
between Inflation and Unemployment
Although a higher level of prices is, in the long run, the primary effect of increasing the quantity
of money, the short-run story is more complex and controversial.
Most economists describe the short-run effects of monetary injections
as follows:
• Increasing the amount of money in the economy stimulates the overall level of spending and
thus the demand for goods and services.
• Higher demand may over time cause firms to raise their prices, but in the meantime, it also
encourages them to hire more workers and produce a larger quantity of goods and services.
• More hiring means lower unemployment. This line of reasoning leads to one final economy-
wide trade-off: a short-run trade-off between inflation and unemployment. Although some
economists still question these ideas, most accept that society faces a short-run trade-off between
inflation and unemployment. This simply means that, over a period of a year or two, many
economic policies push inflation and unemployment in opposite directions. Policymakers face
this trade-off regardless of whether inflation and unemployment both start out at high levels (as
they did in the early 1980s), at low levels (as they did in the late 1990s), or someplace in
between. This short-run trade-off plays a key role in the analysis of the mbusiness cycle—the
irregular and largely unpredictable fluctuations in economic activity, as measured by the
production of goods and services or the number of people employed. Policymakers can exploit
the short-run trade-off between inflation and unemployment using various policy instruments. By
changing the amount that the government spends, the amount it taxes, and the amount of money
it prints, policymakers can influence the overall demand for goods and services. Changes in
demand in turn influence the combination of inflation and unemployment that the economy
experiences in the short run. Because these instruments of economic policy are potentially so
powerful, how policymakers should use these instruments to control the economy, if at all, is a
subject of continuing debate. This debate heated up in the early years of Barack Obama’s
presidency. In 2008

8. and 2009, the U.S. economy, as well as many other economies around the world, experienced a
deep economic downturn. Problems in the financial system, caused by bad bets on the housing
market, spilled over into the rest of the economy,
causing incomes to fall and unemployment to soar. Policymakers responded in various ways to
increase the overall demand for goods and services. President Obama’s first major initiative was
a stimulus package of reduced taxes and increased government spending. At the same time, the
nation’s central bank, the Federal Reserve, increased the supply of money. The goal of these
policies was to reduce unemployment. Some feared, however, that these policies might over time